CCAR | Stress Test Follies & Zombie Banks

Listening to the media await the release of the latest bank stress tests from the Fed, one is reminded that bank supervision is not the first and foremost concern of the central bank. Froth in the equity and housing markets are seen as better indicators of policy success than job creation or credit expansion. With the US economy entering another speculative phase c/o quantitative easing, Wall Street is jubilant at the prospect of further capital and loan loss releases by the banks. But be careful what you wish for in this case. We have all seen this movie before.

The Fed and other regulators have made an enormous fuss about raising bank capital levels over the past several years. Yet the stated intent of the Comprehensive Capital Analysis and Review (CCAR) of 19 firms as well as the Capital Plan Review (CapPR) of an additional 11 bank holding companies with $50 billion or more of total consolidated assets is to allow increased return of capital to investors. This public evidence of schizophrenia on the part of regulators goes largely unnoticed in the press.

The Fed notes correctly that the large banks have greatly increased capital levels, this as leverage has fallen. In my last post, “Zombie Love, True Sales and Why “Too Big To Fail” is Really Dead,” we noted that changes made to the rules for “true sales” by the FDIC in 2011 have greatly reduced the ability of banks to create off balance sheet (OBS) leverage via securitizations. Perhaps this is why the large bank peer group continues to wallow in mediocrity with ROE levels in high single digits and flat to down loan volumes. Just Take a look at the line items for 1-4 mortgages and securitization sales in the latest FDIC Quarterly Banking Profile.

Like utilities, the banks are anxious to increase the payout on common equity to appease unhappy investors. And the Fed is happy to facilitate, even to the extent of allowing the banks to set their own capital adequacy parameters as part of the process:

"…the Federal Reserve's assessment of capital plans under CapPR will not be based on supervisory estimates derived from independent supervisory models, but instead solely on an assessment of the firms' own capital plans and internal capital planning and stress testing practices that support them."

The curtailment of OBS leverage focused on housing is significant for a number of reasons. First, driven by the idiotic Basel III framework, the large banks must now focus even more attention on OTC derivatives and structured products as they retreat from traditional business lines like residential and commercial mortgage lending.

Unless the loan is subsidized by Uncle Sam via programs like HAMP and HARP, the big banks don’t want to know. The Basel III risk weights for mortgage lending are so severe that they will literally force the largest banks to withdraw from the bottom half of the US mortgage sector. Nowhere in the CCAR capital adequacy scenario will you see any discussion of legacy mortgage risk and litigation, this even though the instructions for the tests specifically require banks to focus on risks “not explicitly covered in information requested” in the various disclosures for the CCAR process.

Nor will there be any discussion of the possibility that a new, Fed-induced bubble in the stock market will result in higher losses to banks via derivative exposures over the time frame of the CCAR stress scenarios. Remember, the net effect of Basel III and Dodd Frank is to make the TBTF banks even more dependent upon derivatives, investment banking and capital markets business lines for profits than ever before.

The idea that the Fed will allow higher capital payouts by large banks illustrates the grotesque situation in Washington when it comes to bank regulation. Weak profitability and slow revenue growth should be the key areas of concern in the CCAR analysis, but there will be no discussion of these factors. Nor will banks be asked to model their forward capital needs in a “normal” interest rate environment. The Fed is currently subsidizing the cost of funds for banks via QE to the tune of about $100 billion per quarter, but we won’t talk about that either.

Instead, the Fed allows the banks to manipulate measures such as “risk weighted assets” to allow for greater short-term payouts to investors. Some media observers see the CCAR process as evidence of higher equity returns by the TBTF banks, but all we are really seeing is the prospect of higher returns of capital to investors. Even as regulators avert their eyes from issues like OTC derivatives, festering second lien exposures and the prospective re-default of modified mortgages, the Fed will allow the largest TBTF banks to pay out ever greater portions of their capital to yield-starved investors.

In the absence Basel III, Dodd-Frank and financial repression via QE, would the zombie banks be so anxious to expand shareholder payouts? The answer to that question is obviously no. As Morpheus said to Neo in the film The Matrix: You still think that is air you are breathing?